03/29/89 In Re Liquidation of Security Casualty Company (John E.

March 29, 1989

IN RE LIQUIDATION OF SECURITY CASUALTY COMPANY (JOHN E.

Before the rehabilitation proceedings were initiated, shareholders of Security America Corporation had brought actions against the company alleging fraud in the sale of its shares. The Securities and Exchange Commission halted trading in Security America stock on April 20, 1981, and a number of suits were filed by Security America shareholders in the months following. The actions were consolidated in the United States District Court for the Northern District of Illinois in a proceeding entitled In re Security America Corporation Securities Litigation, No. 81 -- C -- 3910 (hereinafter, the Federal action). The shareholders subsequently filed a consolidated complaint, asserting violations of several Federal and State securities laws. The gravamen of the shareholders' action was that the registration statement and prospectus used in connection with Security America's stock sale contained misstatements and omissions of material fact concerning the business activities and financial condition of Security America and its subsidiary, Security Casualty. Named as defendants in the shareholders' action were Security America Corporation and its directors, the Director of Insurance, in his capacity as liquidator of Security Casualty, the underwriters of the Security America stock offering, and the accounting firm that had certified the financial statements appearing in the registration statement and prospectus. In May 1982 the Federal district Judge certified the class and certain class representatives. The class consisted of investors who had purchased Security America stock during the period from November 20, 1980, the date of the initial public offering, through April 19, 1981, the day before trading in the stock was halted.

SUPREME COURT OF ILLINOIS

Washburn, Director of Insurance, Appellant, v.

Peter Dyson et al., Appellees)

537 N.E.2d 775, 127 Ill. 2d 434, 130 Ill. Dec. 446 1989.IL.425

Appeal from the Circuit Court of Cook County, the Hon. David J. Shields, Judge, presiding.

APPELLATE Judges:

JUSTICE MILLER delivered the opinion of the court. WARD, CLARK and CALVO, JJ., took no part in the consideration or decision of this case.

DECISION OF THE COURT DELIVERED BY THE HONORABLE JUDGE MILLER

The question presented by this appeal concerns the priority to be accorded to the claims of defrauded shareholders of an insurance company that is undergoing liquidation pursuant to the Illinois Insurance Code (Ill. Rev. Stat. 1987, ch. 73, pars. 613 through 1065.906). A class of shareholders of Security America Corporation was permitted to intervene in liquidation proceedings brought by the Director of Insurance against Security Casualty Company, a domestic company and a wholly owned subsidiary of Security America. The Security America shareholders had established, in a separate action in Federal court, the commission of securities law violations by Security America and its directors in connection with a public offering and sale of Security America stock. The shareholders filed a proof of claim in the liquidation proceedings, requesting the imposition of a constructive trust on proceeds of the Security America stock offering that were in the possession of Security Casualty. A Judge of the circuit court of Cook County agreed with the shareholders and imposed a constructive trust on almost $8 million of the Security Casualty estate; the circuit Judge denied the shareholders' request for prejudgment interest on their claim. The Insurance Code accords claims of shareholders lowest priority in distribution from the assets of a company in liquidation, and the effect of the circuit court's decision was to advance the shareholders' claims ahead of all others. The present appeal, challenging the imposition of the constructive trust, is brought by the Director of Insurance, in his capacity as liquidator of Security Casualty Company, and by the Illinois Guaranty Fund, the Texas Property and Casualty Guaranty Association, and certain other nonresident State insurance guaranty funds and associations, intervenors in the proceedings below. As cross-relief, the shareholders contend that the circuit Judge erred in denying their request for prejudgment interest. We allowed the parties' motion for a direct appeal to this court under Rule 302(b) (107 Ill. 2d R. 302(b)).

The facts giving rise to the instant appeal are not in dispute. In 1980 the Department of Insurance informed Security Mutual Casualty Company, a domestic entity, that the company would face sanctions, and would possibly be liquidated, if it failed to increase its capital by year-end. Security Mutual was a direct writer of automobile insurance policies and also was a reinsurer under a variety of treaties. To raise the required capital, the directors of Security Mutual decided to "demutualize" the company and convert it to stock ownership. Under the demutualization plan developed by management, Security Mutual was to change its name to Security Casualty Company; a holding company, Security America Corporation, was to be formed; and Security America was to sell stock to the public and use the proceeds to purchase all the shares of Security Casualty. The public offering of Security America stock was made in November 1980, and some 2.75 million shares were sold at a price of $6 per share, raising $16.5 million. After paying underwriting and brokerage fees, Security America transferred the net proceeds, about $14.2 million, to Security Casualty in exchange for all the shares of stock of Security Casualty. The two companies were controlled by the same management, and Security America had no business activities apart from its ownership of Security Casualty.

On August 14, 1981, the Director filed a complaint in the circuit court of Cook County seeking liquidation or rehabilitation of Security Casualty. The Director alleged that Security Casualty was insolvent and had a negative net worth of $20 million. The board of directors of Security Casualty voted to submit voluntarily to rehabilitation proceedings, and on August 17, 1981, an agreed order was entered appointing the Director rehabilitator of the company. About two months later, on October 14, 1981, the Director filed an amended complaint for liquidation of the company with a finding of insolvency. Security Casualty opposed the action, denying that it was insolvent and moving for dismissal of the complaint. On December 4, 1981, the circuit court entered an order of liquidation with a finding of insolvency and authorized the Director to liquidate Security Casualty. Later that month the circuit court entered an order setting a deadline of July 31, 1982, for the submission of claims against the estate of Security Casualty.

On July 7, 1982, the shareholders moved to intervene in the Security Casualty liquidation proceedings in circuit court and filed a proof of claim. In their proof of claim the shareholders maintained that the net proceeds of the Security America stock sale had been transferred to Security Casualty, and they asked for the imposition of a constructive trust on the funds. Relying on the allegations of securities law violations at issue in the pending Federal class action, the shareholders contended that the stock sale had been effected through fraudulent means and that the proceeds of the sale therefore should not be deemed part of Security Casualty's estate for purposes of distribution under the Insurance Code. The shareholders instead asked that the funds be impressed with a constructive trust for their benefit. On July 13, 1982, the circuit court allowed the shareholders' motion to intervene in the liquidation proceedings.

In an order entered July 20, 1984, nunc pro tunc July 26, 1983, the circuit Judge lifted previously entered orders staying the proceedings in the Federal action but retained exclusive jurisdiction over the priority and constructive trust issues. The circuit court's order permitted the shareholders to pursue the merits of their Federal action against Security America. On November 1, 1985, the Federal district court granted the shareholders summary judgment against Security Casualty on count III of the consolidated complaint; count III alleged violations of section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j (1976)) and of rule 10b -- 5, promulgated thereunder. The district court's order came in the wake of an extensive stipulation entered into by the shareholders and the Director, as liquidator of Security Casualty, concerning the parties' misconduct in connection with the Security America stock offering. The district Judge found that the Security America registration statement and prospectus contained false statements and omissions of material fact; that Security Casualty, through its agents, had acted with the intent to deceive, manipulate, and defraud investors; that the representative class plaintiffs had detrimentally relied on the material misstatements and omissions in the Security America registration documents; and that the shareholders had established Security Casualty's violations of section 10(b) of the Securities Exchange Act of 1934 and of rule 10b -- 5. On July 15, 1986, the district Judge entered judgment of $15,184,950.66 in favor of the shareholders and against Security America and Security Casualty.

Following entry of the district court's judgment, the shareholders returned to circuit court to enforce the award. On August 20, 1986, the shareholders filed a motion in the Security Casualty liquidation proceedings seeking imposition of a constructive trust. The shareholders asked the circuit Judge to declare that the Director, as liquidator, was holding in trust funds received by Security Casualty from the Security America stock offering. The shareholders requested a judgment of $7,799,950.66, which represented the unsatisfied portion of the Federal judgment, after the deduction of a total of $7,385,000 received by the shareholders in settlement of their claims against a number of other defendants.

The shareholders' motion for imposition of a constructive trust was opposed by the Director and by the Illinois Insurance Guaranty Fund, the Texas Property and Casualty Guaranty Association, and certain nonresident State insurance guaranty funds and associations, whose requests to intervene in the liquidation proceedings had previously been allowed. In an order entered February 8, 1988, the circuit Judge granted the shareholders their requested relief. The Judge ruled that through Federal securities law violations identifiable funds of the shareholders had come into the possession of Security Casualty, and then into the possession of the Director, as liquidator of the company. Because a constructive trust arises as the impropriety occurs, the circuit Judge ruled that Security Casualty never obtained equitable title to the funds, and the Judge concluded that the funds were not subject to distribution under section 205. The circuit ...

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